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Section 3 - Equity Investments > MIP 8 - Alternative Investments Portfolio Management > Flashcards

MIP 8 - Alternative Investments Portfolio Management Flashcards

1
Q

List Examples of Common Alternative Investments

A
  1. Real estate
  2. Private equity
  3. Commodities
  4. Hedge funds
  5. Managed futures
  6. Distressed securities
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2
Q

Define alternative investments.

A

Groups of investments with risk and return characteristics that differ markedly from those of traditional stock and bond investments

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3
Q

What are common features of alternative investments?

A
  1. Relative illiquidity (which generates a return premium)
  2. Diversifying potential relative to stocks and bonds
  3. High due diligence cost due to complex investment structures and opaque reporting
  4. Difficult performance appraisal
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4
Q

Define due diligence.

A

The investigation into the details of a potential investment, including scrutiny of operations and management and the verification of material facts

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5
Q

Roles played by alternative investments in a portfolio

A
  1. Provide exposure to risk factors not easily accessible through traditional investments
  2. Provide exposure to specialized investment strategies
  3. Any combination of the above two
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6
Q

Define mass affluent

A

Segment of the private wealth marketplace that is not sufficiently wealthy to command certain individualized services at many investment firms (roughly $100,000 to 1 million)

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7
Q

Private wealth client considerations of Alternative Investments

A
  1. Tax issues
    • Partnerships can make it very complicated
  2. Determining suitability
    • Often multistage time horizons and liquidity needs
    • Changes can occur quickly
  3. Communication with client
    • Difficult to explain complex investments to individuals
  4. Decision risk
    • There is a risk of changing strategies at the point of maximum loss
    • Must manage risk during the investment horizon as well as at the end
  5. Concentrated equity position of client in closely held company
    • Could be a substantial portion of an individual’s wealth
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8
Q

Define real estate

A

ownership interests in land or structures attached to land

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9
Q

Types of Real Estate Investments

A
  1. Direct
    • Residences
    • Business (commercial)
    • Agricultural land
  • Indirect
    • Companies engaged in real estate development or management
    • Real estate investment trusts (REITs)
    • Commingled real estate funds (CREFs)
    • Infrastructure funds
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10
Q

Real estate investment trusts (REITs)

A
  • Publicly traded equities representing pools of money invested in real estate properties
  • Equity REITs own and manage properties
  • Mortgage REITs own portfolios in which more than 75% of the assets are in mortgages
  • Hybrid REITs buy real estate and acquire mortgages
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11
Q

Commingled real estate funds (CREFs)

A
  • Includes open-end and closed-end funds
  • Closed-end funds are usually more leveraged
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12
Q

Infrastructure funds

A
  • Private investments in public infrastructure projects (e.g. roads, schools)
  • Usually a group of private companies designs, finances, and builds the new project
  • The public sector leases the infrastructure for a period of time
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13
Q

NCREIF

A
  • NCREIF is a popular property index benchmark used to measure the performance of direct real estate investment in the US
    • Covers a sample of commercial properties owned by large US institutions
    • It is a value-weighted quarterly index
    • Property appraisals are conducted infrequently (e.g. annually)
  • NAREIT is the most common indirect investment index
    • NAREIT is a real-time, market-cap weighted index of all REIT’s actively traded on the New York Stock Exchange
    • Significant measurement issues
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14
Q

Describe the investment characteristics of real estate.

A

Investment characteristics of real estate:

  1. Lack of liquidity
  2. Large lot sizes
  3. High transaction costs
  4. Heterogeneity
  5. Immobility
  6. Low information transparency
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15
Q

Roles of Real Estate in Investment Portfolios

A
  • Strategic allocations to real estate are about 7% in the United States
  • Real estate markets follow economic cycles
  • The Role of Real Estate as a Diversifier
    • Real estate is not highly correlated with stocks and bonds
    • It is not as affected by short-term economic conditions
    • Adding REITs can really increase the Sharpe ratio (Diversification benefits with Direct real estate)
    • Direct real estate investment has more diversification benefits than indirect investments (e.g. REITs)
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16
Q

Describe the advantages of real estate investing.

A
  1. Tax subsidies (e.g. mortgage interest, property tax, and other expenses are deductible)
  2. Allow for financial leverage
  3. Direct control over property
  4. Can diversify geographically
  5. Relatively low return volatility
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17
Q

Describe the disadvantages of real estate investing.

A
  1. Not easy to divide into smaller pieces (results in too much concentration)
  2. Information cost high
  3. High commissions paid to brokers
  4. Substantial operating and maintenance costs
  5. Exposed to neighborhood deterioration
  6. Tax deductions subject to political risk
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18
Q

Diversification within Real Estate Itself

A
  • Can diversify by type and geography
  • Commercial rental income is often stable
  • Apartments appear to have higher returns and less volatility compared to large office assets over the last decade
    • This could be due to the apartment sector’s low correlation with inflation
  • Direct markets demonstrate serial correlations in returns (positive following positive and negative following negative)
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19
Q

Why is it problematic using appraisal-based values in Real Estate Benchmarks?

And how to overcome that?

A
  • unadjusted appraisal-based real estate returns were low with low volatility and correlations with othet asset classes thus overstating diversification benefits
    • ​due to infrequency of appraisals
  • The unsmoothing corrects for this bias
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20
Q

Attributes of a good real estate index

A
  • Index based on appraisal-based property values
  • Index is diversified geographically and by property type
  • Index is investable and unambiguous
  • Index is unlevered - for unlevered funds
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21
Q

Define private equity and describe private equity funds

A
  • Private equity: ownership interests in non-publicly traded companies
  • Private equity funds: the pooled investment vehicles through which many investors make (indirect) investments in generally highly illiquid assets
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22
Q

Describe private equity investment characteristics.

A
  1. Illiquidity (sharp discount for minority holders)
  2. Long-term commitments required
  3. Higher risk than seasoned public equity investment
  4. High expected IRR required (e.g. 25%)
  5. Limited information
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23
Q

Describe carried interest.

A

The share of the private equity fund’s profits that the fund manager is due once the fund has returned the outside investors’ capital

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24
Q

Describe claw-back provisions.

A

Specifies that money from the fund manager be returned to investors if at the end of a fund’s life investors have not received back their capital contributions and contractual share of profits

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25
Q

Describe the J-curve.

A

Early returns are negative as the portfolio of companies burns cash but
later returns accelerate

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26
Q

Describe venture capital (VC).

A

Refers broadly to the pools of capital managed by specialists known as venture capitalists who seek to identify privatly held companies that have great business opportunities but need financial (equity and equity-linked), managerial, and strategic support

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27
Q

Issuers and Suppliers of Venture Capital

A
  1. Issuers:
    • Formative-stage companies
    • Expansion-stage companies
  2. Suppliers:
    • Angel investors
    • Venture capital
    • Large companies
28
Q

Issuers of Venture Capital by Stage

A
  1. Formative-stage companies
    • Ranges from companies just starting to ones just starting to market products
  2. Expansion-stage companies
    • Ranges from young companies that need financing to companies preparing for an IPO
29
Q

Financing Stages of Venture Capital

A
  1. Early-stage financing
    • Seed (provided to entrepreneur to test idea)
    • Start-up (company formed and idea proven, but no revenue yet)
    • First stage (needed if seed and start-up financing exhausted)
  2. Later-stage financing (funds for expanding sales)
30
Q

Describe angel investors.

A

An accredited individual investing chiefly in seed and early-stage companies, sometimes after the resources of the founder’s friends and family have been exhausted

31
Q

Buyout Funds

A

Larger segment than venture capital

  1. Mega-cap (take public company private)
  2. Middle-market
    • purchase private companies whose revenues and profits are too small to access capital from the public equity markets
32
Q

Way in wich Buyout Funds Add Value

A
  1. Restructuring operations and improving management
    • Use a pool of competent executives
  2. Buying companies at a discount to intrinsic value
  3. Adding or restructuring debt
33
Q

Describe corporate venturing.

A

When companies invest their own money via corporate private equity in promising young companies in the same or a related industry

34
Q

Describe dividend recapitalization

A

Used by buyout funds managers and involves the issuance of debt to finance a special dividend to owners (sometimes refinancing existing debt in the process)

35
Q

Differences in return characteristics for VC funds and buyout funds

A
  1. Buyout funds are usually highly leveraged
  2. Cash flows to buyout fund investors come earlier and are often steadier
    • The return pattern for VC funds is often described as a J-curve; the first several years are negative
  3. Returns to VC fund investors are subject to greater error in measurement
36
Q

Issues to address in formulating Private Equity strategy

A
  1. Ability to achieve sufficient diversification
    • Need a large fund because institutional partnership commitments are big
  2. Liquidity of the position
    • Should plan for 7 to 10 years; if sell early, it is usually at a steep discount
  3. Provision for capital commitment
    • The commitment period is usually 5 years
  4. Appropriate diversification strategy
    • Consider effect on overall risk, not just stand-alone risk
    • Can diversify by sector, stage, and geography
37
Q

Define commodities

A

Articles of commerce such as agricultural goods, metals, and
petroleum

38
Q

Types of Commodity Investments

A
  1. Direct
    • Cash market physical purchase of commodities
      • Incur storage costs
  2. Indirect
    • Purchase equity in companies that specialize in commodity production
      • There is imperfect correlation between equity in commodity-linked companies and commodity price changes
39
Q

State three roles of commodities in a portfolio.

A
  1. Portfolio risk diversifier
    • Often best diversification when big changes in unexpected inflation
  2. Inflation hedge
    • Useful if liabilities are positively correlated with inflation (e.g. pensions, endowments)
  3. Active management potential
40
Q

Why does market-cap weighting not work for Commodity Indices?

A
  • Market-capitalization of a futures contract is always zero
  • Some use world-production weightings
41
Q

Components of returns on commodity futures contracts

A
  1. Spot return
    • Changes in the underlying spot prices will affect futures prices
    • It will affect short maturity contracts more
  2. Collateral return
    • Assume full value of underlying futures contract is earning the risk-free yield
  3. Roll return
    • Change in the futures contract price minus the change in the spot price
42
Q

Backwardation and Conango impact on Roll return for commodity futures

A
  • Backwardation
    • longer-dated futures contracts have lower prices
    • positive return will be earned with a buy-and-hold strategy
  • Contango
    • longer-dated futures contracts have higher prices
43
Q

Commodity Convenience Yield

A
  • Nonmonetary benefit of owning spot commodity
  • Higher convenience yields should lead to higher roll returns; this is more pronounced for nonperishable, storable products
  • The difference between futures price and spot price is due to forgone interest, storage costs, and convenience yields
  • Futures price ≈ Spot price (1 + r) + Storage costs − Convenience yield.
44
Q

Determinants of Commodity Returns

A
  1. Business cycle-related supply and demand
    • Prices are determined by the supply and demand of the underlying commodity
  2. Convenience yield
    • Nonmonetary benefit of owning spot commodity
  3. Real options under uncertainty
    • Futures prices are often below current spot prices (backwardation)
    • Producers are holding real options to increase production; will only exercise if prices increase
45
Q

Hedge Funds by Style

A
  1. Equity Market Neutral
  2. Convertible Arbitrage
  3. Fixed-Income Arbitrage
  4. Distressed Securities
  5. Merger Arbitrage
  6. Hedged Equity
  7. Global Macro
  8. Emerging Markets
  9. Fund of Funds
46
Q

Broad Strategies of Hedge Funds

A
  1. Relative value
  2. Event driven
  3. Equity hedge
  4. Global asset allocators
  5. Short selling
47
Q

Convertible Arbitrage Style for Hedge Funds

A
  • Invest in convertible bonds, warrants, and convertible preferred stock
    • For example, could purchase a convertible bond and sell the stock
48
Q

Equity Market Neutral Style for Hedge Funds

A
  • Buy undervalued stocks and sell overvalued ones while maintaining no net market risk
  • Short-selling is restricted for many investors, so excess returns are possible
49
Q

Merger Arbitrage Style for Hedge Funds

A

Seek to capture price spread of security before and after merger

50
Q

Hedged Equity Style for Hedge Funds

A
  • Identify overvalued and undervalued equity securities
  • Not market neutral
51
Q

Global Macro Style for Hedge Funds

A

Take advantage of systematic global market moves

52
Q

Issues in Selecting and Using Hedge Fund Indices

A
  1. Biases in Index Creation
  2. Relevance of Past Data on Performance
  3. Survivorship Bias
  4. Stale Price Bias
  5. Backfill Bias (Inclusion Bias)
53
Q

Performance Appraisal Measures for Hedge Funds

A
54
Q

Performance Evaluation Concerns for Hedge Funds

A
  1. Returns
  2. Volatility and Downside Volatility
  3. Performance Appraisal Measures
  4. Correlations
  5. Skewness and Kurtosis
  6. Consistency
55
Q

Other issues in selecting Hedge Funds

A
  1. Young funds outperform old funds
  2. Small funds outperform large funds
  3. Funds of funds provide closer return approximations than indices
56
Q

Downside Deviation

A
  • Better measure of risk for hedge funds
  • Focuses on devaitions below a given threshold
57
Q

Drawdown

A
  • Popular risk measure for hedge funds
  • It is the difference between a portfolio’s maximum net asset value and any subsequent low point (until a new high water is reached)
58
Q

Limitations of the Sharpe ratio for measuring hedge fund perfomance

A
  1. Sharpe ratio is time dependent; increases proportionally to the square root of time
  2. Not appropriate if investment has an asymmetrical return distribution
  3. Illiquid holdings bias the ratio upward
  4. Overestimated if returns are serially correlated; this can happen with stale prices
  5. Works best for stand-alone investments
    • does not take into consideration the correlations with other assets in a portfolio
  6. No predictive ability: not likely to predict future winners among hedge fund managers
  7. Can game the ratio (e.g. lengthen measurement interval, compound returns, write out of the money options, smoothing returns, getting rid of extreme returns)
59
Q

Consistency of hedge fund returns

A

Number of positive return months and average monthly returns in up and down markets

60
Q

Trading Stretegies for Managed Futures

A
  • Systematic rule-based models
  • Discretionary approaches
61
Q

Investment Characteristics for Managed Funds

A
  • Derivative markets are a zero-sum game
  • Managed futures accounts can only generate real returns if other parties lose
  • Hedgers may be willing to lose money on average to hedge a risk
  • CTAs look for arbitrage opportunities
  • There is evidence of performance persistence
  • Most use momentum strategies
62
Q

Distressed Securities

A
  • Distressed securities are in financial trouble or near bankruptcy
  • Some have already filed for Chapter 11 protection
  • Many investors are not allowed to hold below-investment-grade securities due to regulatory or investment policy restrictions
  • Also analysts often do not cover distressed securities and this might lead to unresearched opportunities that could be undervalued
63
Q

Risk to assess when investing in Distressed Securities

A
  • Event risk (low correlation with general stock market)
    • Unexpeted company specifit event
  • Market liquidity risk: significanlty lower for distressed securities
  • Market risk: changes in economy and interest rates (not as important)
  • J factor risk
    • Judge’s track record in adjudicating bankruptcies and restructuring
64
Q

Prepackaged Bankruptcy Filing for Distressed Securities

A
  • The debtor agrees in advance with creditors before Chapter 11 is formally filed
  • This expedites the bankruptcy process
65
Q

Define managed futures

A

Pooled investment vehicles in futures and options on futures, frequently structured as limited partnerships

Section 3 - Equity Investments (7 decks)

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